Why QE3 is a Real Possibility

The market has been very crazy the past two weeks: gold rallied for the first time above $1,800, S&P plummeted to 1,131 to mark a new year-to-date low, and EUR/USD traded wildly within a huge 400-pip range.

I don’t like breaking trends so I’ll make it even crazier. In my post today, I’m going to talk about three important reasons why a third round of quantitative easing from the Federal Reserve is highly possible!

Reason 1: Recession fears have escalated

Ever since the end of QE2, the U.S. economy has not lived up to expectations. This is an incontestable fact. The economy is simply muddling through, as the positive effects of QE2 were unsustainable. Recent leading indicators on the manufacturing sector and consumer sentiment show this clearly.

The Philadelphia Fed Index, which is a leading indicator of business health, disappointed greatly as it printed a -30.7 reading in August instead of 7. In the past, when the index had gone that low, a recession followed.

The weakness of the U.S. economy has also been repeated many times not only by economists, but by important officials such as FOMC President Ben Bernanke and U.S. President Barrack Obama. In fact, several days ago, Obama announced that has been preparing a stimulus program that includes tax cuts and infrastructure spending to boost growth.

A fresh round of QE3 may be needed to save the U.S. from another recession.

Reason 2: The core of the FOMC is dovish

While there were new dissenters (voting members Charles Plosser, Richard Fisher, and Kocherlakota ) to last week’s FOMC’s decision to keep monetary policy extra-accommodative until mid-2013, the rest of the FOMC remains dovish.

In addition, the Federal Reserve is arguably the most aggressive central bank when it comes to making changes in monetary policy to promote growth. If you recall, the Federal Reserve was one of the first among the major central banks to cut rates to ultra-low levels and implement quantitative easing to support the economy.

Reason 3: The U.S. government needs money

Just a few weeks ago, the U.S. Congress approved a plan to raise the debt ceiling by a whopping $2.4 trillion. To repay debt and fund the U.S. government’s spending, the National Development and Reform Commission (China’s top economic planner) says that the Fed could launch a fresh round of quantitative easing.

Is QE3 inevitable?

Heck no!

One of the biggest roadblocks to the implementation of QE3 was the unexpected jump in the U.S. inflation rate. The most recent U.S. consumer price index showed a 0.5% rise, more than two times the 0.2% forecast.

I know it’s still far from the Fed’s 1.7%-2.0% inflation target, but it did result in fears that inflation may spiral out of control if another round of QE3 were to be carried out.

The upcoming Jackson Hole symposium on Friday will be a very important event for the market as it will offer us with clues as to whether QE3 was a go or no-go. It is in the Jackson Hole meeting last year that Ben Bernanke talked and hinted about QE2.

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